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Chapter 8 Outline

Study Objective 1 - Identify the Different Types of Receivables


The term receivables refers to amounts due from individuals and companies.
Receivables are claims that are expected to be collected in cash.
Receivables represent one of a companys most liquid assets.
Receivables are frequently classified as:
Accounts receivable
Are amounts owed by customers on account.
Result from the sale of goods and services (often called trade receivables.
Are expected to be collected within !" to #" days.
are usually the most significant type of claim held by a company.
!otes receivable
Represent claims for which formal instruments of credit are issued as evidence of
debt.
Are credit instruments that normally require payment of interest and extend for
time periods of #"$%" days or longer.
&ay result from sale of goods and services (often called trade receivables.
Other receivables
'ontrade receivables including interest receivable( loans to company officers(
advances to employees( and income taxes refundable.
)enerally classified and reported as separate items in the balance sheet.
Study Objective " - #$plain ho% Accounts Receivable are Reco&ni'ed in the
Accounts
Two accounting problems associated with accounts receivable are:
*. Recogni+ing accounts receivable
,. -aluing accounts receivable
Reco&ni'in& accounts receivable
Service or&ani'ations $$ A receivable is recorded when service is provided on
account.
.ebit accounts receivable and credit service revenue
(erchandisers / A receivable is recorded at the point of sale of merchandise on
account.
.ebit accounts receivable and credit sales
Receivable may be reduced by sales discount and0or sales return
)aluin& accounts receivable
1ome accounts receivable will become uncollectible.
This creates bad debt e$pense / a normal and necessary ris2 of doing business
on credit.
Study Objective * - Describe the (ethods +sed to Account for ,ad Debts
Two methods are used in accounting for uncollectible accounts:
*. .irect 3rite$off &ethod
,. Allowance &ethod
Direct %rite-off -ethod
3hen a specific account is determined to be uncollectible( the loss is charged to ,ad
Debt #$pense.
4or example( assume that 3arden 5o. writes off &. 6. .orans 7,"" balance as
uncollectible on .ecember *,. The entry is:
.ec. *, 8ad .ebts 6xpense ,""
Accounts Receivable$$&. 6. .oran,""
(To record write$off of &. 6. .uran account
8ad debts expense will show only actual losses from uncollectibles.
8ad debts expense is often recorded in a period different from that in which the
revenue was recorded. 'o attempt is made to show accounts receivable in the
balance sheet at the amount actually expected to be received.
9se of the direct write$off method can reduce the usefulness of both the income
statement and balance sheet.
9nless bad debt losses are insignificant( the direct write$off method is not acceptable
for financial reporting purposes.
Allo%ance -ethod
The allo%ance -ethod of accounting for bad debts involves estimating uncollectible
accounts at the end of each period.
:t provides better matching of expenses and revenues on the income statement and
ensures that receivables are stated at their cash .net/ reali'able value on the
balance sheet.
Cash .net/ reali'able value is the net amount of cash expected to be received. :t
excludes amounts that the company estimates it will not collect.
Receivables are therefore reduced by estimated uncollectible amounts on the balance
sheet through use of the allowance method.
The allowance method is required for financial reporting purposes when bad debts
are material.
Three essential features of the allowance method are:
*. 9ncollectible accounts receivable are esti-ated and -atched a&ainst
revenues in the same accounting period in which the revenues occurred.
,. 6stimated uncollectibles are recorded as an increase to ,ad Debts #$pense and
an increase to Allo%ance for Doubtful Accounts (a contra asset account
through an ad;usting entry at the end of each period.
!. Actual uncollectibles are debited to Allo%ance for Doubtful Accounts and
credited to Accounts Receivable at the time the specific account is written off
as uncollectible.
Allowance for .oubtful Accounts shows the estimated amount of claims on customers
that are expected to become uncollectible in the future.
The credit balance in the allowance account will absorb the specific write$offs when
they occur.
Allowance for .oubtful Accounts is not closed at the end of the fiscal year.
8ad .ebts 6xpense is reported in the income statement as an operating expense
(usually a selling expense.
6ach write$off should be approved in writing by authori+ed management personnel.
9nder the allowance method( every bad debt write$off is debited to the allowance
account and not to 8ad .ebt 6xpense.
A write$off affects only balance sheet accounts. 5ash reali+able value in the balance
sheet( therefore( remains the same.
3hen a customer pays after the account has been written off( two entries are
required:
*. The entry made in writing off the account is reversed to reinstate the customers
account.
,. The collection is ;ournali+ed in the usual manner.
The recovery of a bad debt( li2e the write$off of a bad debt( affects only balance
sheet account.
:n <real life(= companies must estimate the amount of expected uncollectible accounts if
they use the allowance method.
4requently the allowance is estimated as a percenta&e of the receivables0
&anagement establishes a percentage relationship between the amount of
receivables and expected losses from uncollectible accounts.
A schedule is prepared in which customer balances are classified by the length of
time they have been unpaid.
8ecause of its emphasis on time( this schedule is often called an a&in& schedule
and the analysis of it is often called a&in& the accounts receivable.
After the accounts are arranged by age( the expected bad debt losses are
determined by applying percentages( based on past e$perience( to the totals of
each category.
The estimated bad debts represent the existing customer claims expected to
become uncollectible in the future.
This amount represents the re1uired balance in Allowance for .oubtful
Accounts at the balance sheet date.
Accordingly( the amount of the bad debts ad;usting entry is the difference
between the required balance and the existing balance in the allowance account.
>ccasionally the allowance account will have a debit balance prior to ad;ustment
because write$offs during the year have e$ceeded previous provisions for bad
debts.
:n such a case( the debit balance is added to the required balance when the
ad;usting entry is made.
Study Objective 2 - Co-pute the Interest on !otes Receivable
A pro-issory note is a written promise to pay a specified amount of money on demand
or at a definite time.
:n a promissory note( the party ma2ing the promise to pay is called the -a3er0
The party to whom payment is to be made is called the payee0 The payee may be
specifically identified by name or may be designated simply as the bearer of the
note.
'otes receivable
give the holder a stronger legal claim to assets than accounts receivable.
are frequently accepted from customers who need to extend the payment of
an outstanding account receivable( and they are often required from high$ris2
customers.
notes receivable( li2e accounts receivable( can be readily sold to another
party. ?romissory notes are negotiable instruments.
There are three basic issues in accounting for notes receivable:
*. Reco&ni'in& notes receivable.
,. )aluin& notes receivable.
!. Disposin& of notes receivable.
The formula for computing interest is:
4ace -alue of 'ote (principle x Annual :nterest Rate x Time (in terms of one year
The interest rate specified on the note is an annual rate of interest. The time factor in
the computation expresses the fraction of a year that the note is outstanding.
3hen the maturity date is stated in days( the time factor is frequently the number of
days divided by !#". 4or example( the maturity date of a #"$day note dated @uly *A is
determined as follows:
Term of note #" days
.ays in @uly !*
.ate of note *A
'otes days in @uly *B
.ays in August !*
?lus notes days in @uly *B
'otes days to the end of August BC BC
&aturity date( 1eptember *C
3hen the due date is stated in terms of months( the time factor is the number of
months divided by *,.
To illustrate the basic entry for notes receivable( the text uses 8rent 5ompanys 7*("""(
two$month( DE promissory note dated &ay *. Assume that the note was written to
settle an open account. The entry for the receipt of the note by 3ilma 5ompany is as
follows:
&ay * 'otes Receivable *("""
Accounts ReceivableF8rent 5ompany *("""
(To record acceptance of 8rent 5ompany note
The note receivable is recorded at its face value( the value shown on the face of the
note.
'o interest revenue is reported when the note is accepted because the revenue
recognition principle does not recogni+e revenue until earned. :nterest is earned
(accrued as time passes.
:f a note is exchanged for cash( the entry is a debit to 'otes Receivable and a credit to
5ash in the amount of the note.
Gi2e accounts receivable( short$term notes receivable are reported at their cash .net/
reali'able value.
The notes receivable allowance account is Allowance for .oubtful Accounts.
The computations and estimations are similar to the ones related to accounts
receivable.
Study Objective 4 - Describe the #ntries to Record the Disposition of !otes
Receivable
'otes may be held to their maturity date( at which time the face value plus accrued
interest is due.
:n some situations( the ma2er of the note defaults( and appropriate ad;ustment must be
made.
A note is honored when it is paid in full at maturity.
A dishonored note is a note that is not paid in full at maturity.
:f the lender expects that it will eventually be able to collect( the 'otes Receivable
account is transferred to an Account Receivable for both the face value of the note and
the interest due.
:f there is no hope of collection( the face value of the note should be written off.
Study Objective 5 - #$plain the State-ent 6resentation of Receivables
6ach of the ma;or types of receivables should be identified in the balance sheet or in the
notes to the financial statements.
1hort$term receivables are reported in the current asset section of the balance sheet
below short$term investments. These assets are nearer to cash and are thus more
liquid.
8oth the gross amount of receivables and the allowance for doubtful accounts should
be reported.
'otes receivable are listed before accounts receivable because notes are more easily
converted to cash.
8ad .ebts 6xpense is reported under <1elling expenses= in the operating expense
section of the income statement.
:nterest Revenue is shown under <>ther Revenues and )ains= in the nonoperating
section of the income statement.
:f a company has significant ris2 of uncollectible accounts or other problems with
receivables( it is required to discuss this possibility in the notes to the financial
statements.
Study Objective 7 - Describe the 6rinciples of Sound Accounts Receivable
(ana&e-ent
&anaging accounts receivable involves five steps:
*. .etermine to whom to extend credit.
,. 6stablish a payment period.
!. &onitor collections.
B. 6valuate the receivables balance.
C. Accelerate cash receipts from receivables when necessary.
.etermine to whom to extend credit.
*. Ris2y customers might be required to provide letters of credit or ban2 guarantees.
,. ?articularly ris2y customers might be required to pay cash on delivery.
!. As2 potential customers for references from ban2s and suppliers and chec2 the
references.
B. ?eriodically chec2 financial health of continuing customers.
6stablish a payment period.
*. .etermine a required payment period and communicate that policy to customers.
,. &a2e sure companyHs payment period is consistent with that of competitors.
&onitor collections.
*. ?repare accounts receivable aging schedule at least monthly.
,. ?ursue problem accounts with phone calls( letters( and legal action if necessary.
!. &a2e special arrangements for problem accounts.
B. :f a company has significant concentrations of credit ris2( it is required to discuss this
ris2 in the notes to its financial statements.
C.
#. A concentration of credit ris2 is a threat of nonpayment from a single customer or
class of customers that could adversely affect the financial health of the company.
Study Objective 8 - Identify Ratios to Analy'e a Co-pany8s Receivables
Giquidity is measured by how quic2ly certain assets can be converted into cash. The
ratio used to assess the liquidity of the receivables is the receivables turnover ratio.
The ratio measures the number of times( on average( receivables are collected during
the period.
The receivables turnover ratio is computed by dividing net credit sales (net sales less
cash sales by the average net accounts receivables during the year.
A popular variant of the receivables turnover ratio is to convert it into an avera&e
collection period in terms of days. This is computed by dividing the receivables
turnover ratio into !#C days.
The general rule is that the average collection period should not greatly exceed
the credit term period (i.e.( the time allowed for payment.
Study Objective 9 - Describe (ethods to Accelerate the Receipt of Cash fro-
Receivables
Two common expressions apply to the collection of receivables:
*. Time is moneyFthat is( waiting for the normal collection process costs money.
,. A bird in the hand is worth two in the bushFthat is( getting the cash now is better
than getting it later or not at all.
There are three reasons for the sale of receivables.
*. The si'e of the receivables may cause a company to sell them because it may not
want to hold such a large amount of receivables . :n recent years( for competitive
reasons( sellers (retailers( wholesalers( and manufacturers often have provided
financing to purchasers of their goods. The purpose is to encourage the sale of the
companys product by assuring financing to buyers.
,. Receivables may be sold because they may be the only reasonable source of cash.
3hen credit is tight( companies may not be able to borrow money in the usual credit
mar2ets or the cost of borrowing may be prohibitive.
!. A final reason for selling receivables is that billin& and collection are often ti-e-
consu-in& and costly. As a result( it is often easier for a retailer to sell the
receivables to another party that has expertise in billing and collection matters.
'ational credit card sales:
Approximately one billion credit cards are recently in use. A common type of credit card
is a national credit card such as -isa and &aster5ard.
Three parties are involved when national credit cards are used in ma2ing retail sales:
(* the credit card issuer( who is independent of the retailer( (, the retailer( and (! the
customer.
A retailer:s acceptance of a national credit card is another for- of sellin&;
factorin&;the receivable by the retailer0
There are several advantages of credit cards for the retailer:
*. :ssuer does credit investigation of customer.
,. :ssuer maintains customer accounts.
!. :ssuer underta2es collection process and absorbs any losses.
B. Retailer receives cash more quic2ly from credit card issuer.
:n exchange for these advantages( the retailer pays the credit card issuer a fee of
,E to BE of the invoice price for its services.
1ales resulting from the use of national credit cards are considered cash sales by the
retailer. 9pon receipt of credit card sales slips from a retailer( the ban2 that issued the
card immediately adds the amount to the sellers ban2 balance.
To illustrate( &organ &arie purchases 7*(""" of compact discs for her restaurant from
1ondgeroth &usic 5o.( and she charges this amount on her -isa 4irst 8an2 5ard. The
service fee that 4irst 8an2 charges 1ondgeroth &usic is ! percent. The entry by
1ondgeroth &usic to record this transaction is:
5ash %A"
1ervice 5harge 6xpense !"
1ales *("""
(To record -isa credit card sales
1ale of receivables to a factor:
A common way to accelerate receivables collection is a sale to a factor. A factor is a
finance company or a ban2 that buys receivables from businesses for a fee and then
collects the payments directly from the customers.
4actoring arrangements vary widely( but typically the factor charges a commission of
*E to !E.

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